AdvancedFixedIncome CallableBonds ProfessorAnhLe

1Whatarecallablebonds?
Whenyoutakeoutafixedratemortgagetobuyahouse,youusuallyhavetheoptionofprepayingthe
mortgage.Thecommontermtouseistorefinance.Andpeoplewouldrefinancetheirmortgages
whenitischeaptodosowheninterestratesarelow.
Callablebondsareverysimilarexceptthatnowcompaniesaretheborrowers.Theyissuecallablebonds
toborrowmoneyforwhateverreason(notnecessarilytobuyhouses).Beingcallable,suchbondsgive
themtherighttocallhomethebondsprepaytheirborrowingswhentheyseefit,whichusually
meanswheninterestratesarelow.
Topayoffthebonds,theissuersusuallyhavetopaytheholderthefacevalueofthebonds.Formany
callablebonds,however,theissuerswillneedtopaysomepremiumontopofthefacevalue.This
premiumactsassomecompensationforthelenderswhouponbeingprepaid,havetofindnew
borrowersatgenerallylowerinterestrates.Thepricethattheissuershavetopayisthecallprice.
Sincecallablebondsareattractivetoborrowers,theyaredislikedbylenders.Althoughlendersget
compensatedthroughhighercouponrateswithcallablebonds,totonedowncallriskswithcallable
bonds,manyissuersintroduceacallprotectionperiodduringwhichacallablebondcannotbecalled.A
typicalcallablebondstructurewilllooklike10NC5:whichmeansthebondhas10yearstillmaturity
andonlycallableafteryear5.
2Whyarecallablebonds?
Itisobviousthatcallablebondsgiveborrowerstheoptiontorefinancewheninterestratesarelow.In
otherwords,itisonewaycompanieshedgeagainstpossibledecreasesinfutureinterestrates.Forthis
reason,callablebondsareverypopularbefore1990.Infact,before1970almostallcorporatebonds
wereissuedwithcallfeatures.Between1970and1990,about80%offixedratecorporatebondswere
callable.Duetothedevelopmentoftheinterestratederivativesmarketsinthelateeightiesandearly
nineties,therehasbeenabigdropincallablebondsissuancenowaccountingforonly30%ofthe
total.Thisisunderstandablesincewithderivatives,itbecomesevereasiertohedgeagainstinterestrate
risks.Withcallablebonds,providersofcapital(lenders)alsoactasinsuranceproviders.Thismaynotbe
necessarilyoptimalthesamewayapersonmaynotbegoodatbothtennisandfinance.Duetocost
savingsfromspecialization,companiesmayfinditmorecosteffectivetoborrowbyissuingstraight
bondsandbuyinsuranceagainstinterestraterisksfromspecializedinsuranceproviders.
However,anotherreasonwhyfirmsmaystillfindcallablebondsdesirableisthatbyissuingcallable
bondstheycansendastrongpositivesignaltothemarketsaboutthequalityoftheirbusiness.The
reasoninggoesasfollows:Ifafirmisconfidentabouttheirbusinessandbelievesthattheircreditquality
willimproveinthefuture(whichwilllowertheirborrowingcosts),itmakessenseforthemtoissuea
callablebond.Assoonasthemarketrealizestheirbettervalues,theycansimplycalltheoldexpensive
bondandreplaceitwithabondwhichpayslowercoupons.Ontheotherhand,ifafirmknowsthatthey
arenotdoingparticularlywellandtheircreditqualityisverylikelytodeteriorate,itmakessensefor
themtoissueanoncallablebondtolockinaborrowingrate.
AdvancedFixedIncome CallableBonds ProfessorAnhLe
3Yieldstocallandyieldstoworst
Tradersliketothinkintermsofyieldtomaturitysimplybecauseitisseeminglyeasiertounderstand.A
bondistradingatayieldof5%seemsmorestraightforwardascomparedtoabondtradingat95.24%
offacevalue.Forthisreason,marketshavecomeupwithyieldsmeasuresforcallablebondsaswell.We
willtalkaboutthesemeasuresinthissection.
Strictlyspeaking,yieldtomaturityisoutofquestionforcallablebonds.Thesimplereasonisthatcallable
bondsdonthavefixedmaturities.Takeforanexample,the10NC5bond(10yearstatedmaturity,only
callableafter5years).Iftheissuer,forsomereasons,decidestocallthebondatendofyear
5/beginningofyear6,thematurityofthebondis5years.However,itisalsopossiblethattheissuer
mayletthebondliveuntilitsusualmaturityof10years.Withoutafixedmaturity,wearenotcertain
aboutthecashflowseitherandassuchayieldtomaturitycannotbecomputed.
However,tradersareinlovewithyieldsmeasuresandthustheyhavecomeupwithatleast2waysof
computingyieldsforcallablebonds.
First,theyassumethatthebond,thoughcallable,willnotbecalledatallduringitsentirelife.In
our10NC5bondexample,thismeansthebondsmaturitywillbe10years.Yieldcomputed
withthisassumptionisstillcalledyieldtomaturity.
Second,theyassumethatthebondwillbecalledwithcertainty.Inour10NC5bondexample,
thismeansthatthebondwillmatureatyear5.Yieldcomputingwiththisassumptionisyieldto
call.Manycallablebondshoweverhavemultiplecalldates.Forexample,our10NC5bondcan
becalledanytimeafteryear5untilyear10.Inthiscase,weneedtobeveryspecificaboutthe
callassumption.Ifweassumethatthebondwillbecalledattheendofyear5withcertainty,
strictlyspeaking,theresultingyieldwillbecalledyieldtofirstcall.
Toavoidpossibleconfusion,letmegiveasimpleexampleforustoquicklygrasptheconcept.Tomakeit
simple,letsworkwitha2yearbondthatcanonlybecalledatendofyear1foracallpriceof$100.This
bond,currentlysellingfor$99,hasafacevalueof$100andispayingasemiannualcouponrateof8%
p.a.
Yieldtomaturity
Tocomputeyieldtomaturityofthiscallablebond,wewillmaketheassumptionthatthebondwillbe
heldtomaturityregardless.Therefore,thecashflowsfromthebondwillsimplybe:
Attime0.5: $4
Attime1.0: $4
Attime1.5: $4
Attime2.0: $104
Theyieldtomaturityofthebondwillthenbeysuchthat:
AdvancedFixedIncome CallableBonds ProfessorAnhLe
99 =
4
1 +
y
2
+
4
[1 +
y
2

2
+
4
[1 +
y
2

3
+
1u4
[1 +
y
2

Solvethisfory,wehave:y=8.55%.
Yieldtocall
Tocomputeyieldtocallofthiscallablebond,wewillmaketheassumptionthatthebondwillbecalled
withcertainty.Therefore,thecashflowsfromthebondwillbe:
Attime0.5: $4
Attime1.0: $4+$100=$104
Theyieldtocallofthebondwillthenbeysuchthat:
99 =
4
1 +
y
2
+
1u4
[1 +
y
2

Solvethisfory,wehave:y=9.07%.
Yieldtoworst
Foracallablebond,yieldtoworstissimplytheminimumbetweentheyieldtomaturityandtheyieldto
call.Intheaboveexample,yieldtoworstissimplyminimumof(8.55%,9.07%)=8.55%.
Awordofcaution
LetsassumethatwegoouttoaBloombergterminaltocheckoutpricesofbondsofcomparablecredit
qualitytothecallablebondaboveandfindoutthefollowing:
A2yearnoncallablebondistradingatayieldof8.5%(orapriceof$99.10)
A1yearnoncallablebondistradingatayieldof8.4%(orapriceof$99.62)
Comparingthepricinginformationheretothatofthecallablebond,itseemsreallyweird.Fromour
calculations,
thecallablebondoffersayieldof8.55%ifitisheldtomaturity.Inthiscase,itscashflowsare
exactlythesameasa2yearnoncallablebondwhichoffersayieldofonly8.5%.
thecallablebondoffersayieldof9.07%ifitiscalledregardless.Inthiscase,itscashflowsare
exactlythesameasa1yearnoncallablebondwhichoffersayieldofonly8.4%.
inotherwords,worstcomestoworst,thebondearnsayieldtoworstof8.55%whichisstill
betterthaneitheroftheyieldsofferedbythe1yearor2yearnoncallablebond.
Itseemsthatthecallableoffershigher(thannecessary)yieldswhencomparedtothenoncallable.Putit
differently,thecallableissellingfor$99whichischeaperthanbothofthe1yearand2yearnon
callable.Whatisgoingon?Isthemarketnotfunctioningwell?Orarewemissingsomething?
AdvancedFixedIncome CallableBonds ProfessorAnhLe
Itturnsoutthatifthemarketisfunctioningwell,thecallableoughttobecheaperthanboththe1year
aswellasthe2yearnoncallable.Toseewhythecallableshouldbecheaperthanthenoncallable
letscomparetheircashflows:
s,
time 1yearNon
callable
2yearNon
callable
callable
0.5 $4 $4 $4
1.0 $104 $4+Marketprice =$4+minimumof($100,market
priceattime 2yearnon
callable)
attime1.0 1.0ofthe

Thesecondcolumncontainscashflowsoft nca .The

thirdcolumncontainsthecashflowsofthe2yearnoncallableuptotime cashflowisof
oursethe$4couponattime0.5.Tocomeupwithacashflowforthe2yearnoncallableattime1.0,I
assumewecollectthecouponof$4andsellthisbondattime1.0.Thecashflowattime1forthisbond
ehowtheissuerofthecallablemakeshis/herdecisionattime
1.0.Itturnsouttobequitesimple.Sincethecallgivestheissuertherighttobuybackthe2yearnon
d
callable,whichislessthanthe
cashflowofthe1yearnoncallable.
.
eenthoseofthe1yearnoncallableand2yearnon
callable.Inotherwords,comparedtoeitherofthenoncallable,thecallableentailsstrictlylessthanor
he1yearno llablewhichisquitestraightforward
1.0.Thefirst
c
willbe$4+itsmarketpriceattime1.0.
Thelastcolumnofthetablecontainscashflowstothecallable.Nothingisspecialaboutthefirstcash
flowsimplyacouponof$4.Thecashflowattime1.0,however,iscrucialsincethisiswherethebond
issuercanexercisetheircallright.Letsse
callablebondattime1.0forapriceof$100,itonlymakessensefortheissuertobuythe2yearnon
callablebackifitissellingformorethan$100attime1.0.Therefore:
Ifthemarketvalueofthe2yearnoncallableislessthan$100,theissuershallnotcallthebon
thecallablewillbethesameasthe2yearnoncallable.Inthiscase,thecashflowofthe
callableattime1.0willbethesameasthatofthe2yearnon
Ifthemarketvalueofthe2yearnoncallableisgreaterthan$100,theissuerwillcallthebond
thecallablewillbethesameasthe1yearnoncallable.Inthiscase,thecashflowofthe
callableattime1.0willbethesameasthatofthe1yearnoncallable,whichislessthanthe
cashflowofthe2yearnoncallable.
Ascanbeseen,theissuersobjectiveistominimizehis/hercashflowobligationsofthecallablebond
Therefore,byexercisingthecallfeatureoptimally,theissuermakessurethatthecashflowofthe
callableattime1.0willbetheminimumbetw
equalcashflows.Assuchitisobviousthatthecallablehastobecheaperthanboththe1yearand2
yearnoncallable.
4Valuationofacallablebond
Youagreethatthecallablebondaboveshouldsellforlessthanthe1yearnoncallableaswellasthe2
yearnoncallable,butexactlyhowmuchless?Ofcourseitiseasyifyouknowthemarketprice.Butwhat
AdvancedFixedIncome CallableBonds ProfessorAnhLe
ifthebonddoesnttradethatfrequent?Sothatyouknow,80%ofbondsnevertrademorethanoncea
year.Insuchinstances,tovalueacallablebond,ourmodelingknowledgebecomeshandy.Thisis
becauseitisquitestraightforwardtovalueacallablebondifwehaveaninterestratetree.Letsassume
wehavethefollowingtreeofsemiannualinterestrates.
0 0.5 1 1.5
15.44%
11.91%
9.19% 11.44%
7.09% 8.83%
6.81% 8.48%
6.54%
6.28%

Asyoumaynotice,therearesomecrazyinterestrates( 44%)inthetree,butthatsallright,every
tree,ifextendedlongenough,wouldgivethat.Importantly,proba forextremeoccurrencesare
uitesmall.Andalso,ourcurrentfocusisonhowtousethetreeforpricing,nothowreasonablethe
treeis.
like15.
bilities
q
Pricingofthe2yearnoncallable
Letsstarttoseehowwecanusethistreetopricethe2yearnoncallable.AndIpromisethatitisa
smoothtransitionfrompricingnoncallablebondstopricingcallablebonds.Rememberthatthecash
:

fcoursedotheusualthingbywalkingbackwardsalongthetree,startingat
Attime1.5,wearenotsurewhatthepriceofthebondwillbe,butweknowthatthereare4

thebondwillsimplybe
104
1+
1S.44%
2
flowsfromthisbondareasfollows
Attime0.5: $4
Attime1.0: $4
Attime1.5: $4
Attime2.0: $104
Topricethisbond,wewillo
time1.5.
scenarios.Ifthe6monthinterestrateis15.44%,theprice(excludingthe$4couponattime1.5)
of = 96.SS.Similarly,ifthe6monthinterestrateattime1.5is

1.At
neutralpricingequation.Forexample,ifweareinthehighestnodeattime1,thepriceofthe
1+
11.91%
2
11.44%or8.48%or6.28%,thevalueofthebondattime1.5wouldbe$98.37,$99.77,$100.83
respectively.
Letstakeastepbacktotime time1,thepriceofthebondcanbecomputedusingtherisk
bondwillbe
0.5(96.55+98.37)+4
= $9S.7S.The$4inthenumeratoris,ofcourse,thecouponthat
wewillreceiveattime1.5regardlessofwhereweare(goingupordown).Ifweareinthe
AdvancedFixedIncome CallableBonds ProfessorAnhLe
middlenode(orthelowestnode),bysimilarcalculations,thepriceofthebondwouldbe98.72
(or101.00).
Nowletstake e0.5.Ifyouareintheuppernode(orlowernode),byvery
Finally,takeastepbacktothecurrenttimetime0.Applyingtheriskneutralpricingequa
onelasttime,thepriceofthebondis
0.5(96.79+100.44)+4
astepbacktotim
similarcalculations,thepriceofthebondwouldbe$96.79(or$100.44).
tion
1+
.09%
2
= $99.1u.
Puttingthebondsvaluesateverynodeofthetreetogether,wewillhavethefollowingpricetree.This

wouldbeattime0.5. owthatitcouldonlybe
either96.79or100.43withequalriskneutralprobabilitiesof50%.The96.79(100.43)pricecorresponds
pricetreecorrespondstotheinteresttreethatwestartwith.Thewayweinterpretthistreeisthesame
ashowweinterprettheinterestratetree.Forexample,weknowthepriceofthebondis$99.10now,
butwearenotsurewhatthepriceofthebond Butwekn
tothescenariowheninterestrateis9.19%(6.81%)attime0.5.Andsoon,eachoftheprice/valuewe
seeherecorrespondstooneinterestratenodeweseeontheinterestratetree.
0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
101.0012
100.8344

OK,youunderstandwhywen erestratetree becauseitallowsustopricethebond

above.Butonceyouhavetheprice(attim that erputtingalltheprices
togethertobuildtheabovepricetree?Whatpurpose rv soutthat,fromtheabove
ee,thepriceofthe2yearcallablebondisonlyafewcalculations nowturntohowwecan
usethetreetopricethe2yearcallablebondwithacallpriceof$100.
eedanint simply
e0),isnt theend?
doesitse
Whyboth
e?Itturn
away.Lets tr
Pricingofthe2yearcallable
Inpricingthe2yearcallable,thekeyisjusttorememberthatattime1theissuerofthecallablewill
optimallyusehis/hercallright.
Attime1.5,ifthecallablehasnotbeencalled,itwillbethesameasa2yearnoncallablebond.
thecallableandthenoncallablemustbeidenticalateverynodeofthe
aycallthebond.However,theissuerwillcallthebondonlyifthevalue
ofthebondishigherthanwhatheneedstopayincallingit:$100.Checkingthe3scenariosat
time1,itonlymakessensefortheissuertobuybackthebondifthevalueofthebondis
$101.00.Paying$100forthebond,effectivelytheissuernets$1.00thankstothecallfeatureof
Assuch,thevaluesof
treeattime1.5.
Attime1.0,theissuerm
AdvancedFixedIncome CallableBonds ProfessorAnhLe
thebond.Onthecontrary,itwillnotmakeanysensefortheissuertocallbackthebondifits
totalvalueiseither95.75or98.72.Insuchinstances,itisbetterfortheissuertoleavethebon
uncalled.Toprice
d
thecallable,therefore,requiresonemodificationinthebondvalueattime1

onthelowestnode.Insteadof101.00,sincetheissuerwouldoptimallycallthebondhere,the
valueofthecallableshouldreallybe$100atthisnode.Thismodification,inturn,willlowerthe
valueofthecallableattime0.5(lowernodeonly)andultimatelythepriceofthecallableat
time0.
Steppingbacktotime0.5,thetotalvalueofthebondattheuppernoderemainsunchanged.
Thetotalvalueofthebondatthelowernodehoweverwillchangeto
0.5(98.72+100)+4
1+
6.81%
2
=
$99.96.
Finally,letstakethestepbacktotime0.Thepriceofthecallablewouldbe:
0.5(96.79+99.96)+4
1+
.09%
2
= $98.87.
Puttingallthevaluesthatwejustcalculatedaboveinatree,wehave:
0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
98.86668 98.716
99.9552 99.7719
100
100.8344

Notethatthedifferencestothetreeofnoncallable sarehighlightedwiththebluecolor.
Thesearethenodesthatareaffectedbyt beingcalledat thatthesenodes
correspondtothelowestbran whereinte sarelow.Thismakessensebecause,as
weknow,bondsarebestcalled/refinanced terestratesar
Pricingofthe2yearcallableWhatifthebondiscallableattim ll?
bondprice
hebonds time1.Note
chofthetree restrate
whenin elow.
e1.5aswe
Ialwaysliketostartthingsoutsimple.ThatswhyIveillustratedhowtopricethecallablebond
e
ent
tnowcallableeitherat
time1withacallpriceof$102orattime1.5withacallpriceof$100.Thekeytopricingthisbondis
it
assumingthatwecanonlycallthebondattime1.Youcanaskthequestionofwhatifthebondcanb
calledattime1.5aswell.Infactmanybondsallowformultiplecalldates.Further,whatifatdiffer
calldates,wehavedifferentcallprices?Fortunately,thoughmorecomplicated,alltheseconcernscan
beaddressedusingthesameframeworkthatwevejustgonethrough.
Letsconsiderthesamecallablebond:face$100,semiannualcouponof8%,bu
simplytostartwiththepricetreeofthenoncallable,andthencheckattime1.5and1,whether
makessensetocallthebondatanyofthenode.
AdvancedFixedIncome CallableBonds ProfessorAnhLe
First,letscheckifitsoptimaltocallthebondattime1.5.Rememberthatthecallpriceattime1.5is
$100.Ifhe/shedoesntcallthebondanddecidestoletthebondliveuntilmaturity,thebondsvaluewill
bethesameasthatofitsnoncallablecounterpart.Assuch,startingwiththepricetreeforthenon
callablebondandfocusonitsvalueattime1.5,wewillbeabletotellwhentheissuerwouldcallthe
bond:onlywhenthevalueofthebondexceeds100.
0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
101.0012
100.8344

0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
101.0012
100

Thetreeontheleftisth ncallablebondprice.Ifyouarewonderingwhe tree

from,Ijustco stedfroma nwewerepricingthenon bond.Ifyoua
f wegotthesenu pleasegoback seem calculationsup now,I
onlypaintor odesattime1 lightthefactthatweare whether
callableattime1.5.
xaminingthe4possiblescenariosattime1.5,itiseasytoseethattheissuerwillonlycallthebondat
thelowestnodewherethevalueofthebondifletalive(untilmaturity)is$100.8344.Assuchforthe

itis
ndanywhereattime1.Youmaybethinking:easystuffweddothesamething
again,checkingforallpossiblescenariosattime1andcomparingthevalueofthenoncallablebondto

tthelowestnodeofthetreeattime1?Itis
simplytheriskneutralexpectedcashflowsdiscountedattheriskfreerateof6.54%.Attime1.0,ifyou
etreeofno reIgotthe
piedandpa bovewhe callable lready
orgothow mbers, and ydetailed there.For
angethen .5tohigh onlychecking itis
E
treeontheright,Ireplacethevalueofthebondatthelowestnodeby100andpaintthenodeblueto
showthatthebondwouldbecalledifwegettothisnode.
Sothatisdoneattime1.5.Thesecondthingwewouldliketodoistogobacktotime1andcheckif
optimaltocallthebo
thecallprice.Ifyouthinkso,thatwouldbetoofast!Beforewegettothatstage,weneedtoadjustthe
bondvaluesattime1toreflectthechange(s)wehavemadetothetreeattime1.5.
Specifically,rememberhowwegetthevalueof101.0012a
areinthelowestnode,weknowthatthevalueofthebondwouldbeeither99.7719or100.8344.As
such,thevalueofthebondincludingthecouponwouldbe:
0.5(99.77+100.83)+4
1+
6.S4%
2
= $1u1.uu12.Thatis,
forthenoncallablebond.Nowforthecallable,wealreadyworkoutthatifthevalueofthebondis
100.83attime1.5,theissuerwillcallthebond.Assuch,thevalueofthebondthebondonthelowest
0.5(99.77+1)+4
nodeattime1.0wouldbe:
1+
6.S4%
2
= $1uu.6u.

AdvancedFixedIncome CallableBonds ProfessorAnhLe

0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
101.0012
100
0 0.5 1 5 1.
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
100.6
100

Onlyafteradjustingthenodesofthe 1asshownabove,wecanproceedandcheck
itisoptimalfortheissue bondattime1.Rememberthatthecallpricea nt.
It up tree time1, value bond $95.75.
is not pay for d node. ertwo s
1,itturnsout for tocallthebondeither. that is
duetothehighcallprice time1. ecallpriceattime1werestill$100,the would
ptimallycallthebondatthelowestnode he/shewouldpay$100forthebondthatisworth
$100.6.
treeattime whether
rtocallthe ttime1isdiffere
is$102.Examining
therefore
the mostnod
$102
eofthe at
atthat
thetotal
Similarly,
ofthe isonly
node
It
worthto
thatitisnot
thebon
theissuer
fortheoth
Youcansee
attime
simply optimal
($102)at
this
issuer Ifth
where

o
Now,goingbacktotime0.5,weneedtoadjustthevalueofthebondatthelowestnodeattime0.5as
well.Thismodificationisnecessaryduetothechangeswemadetothevaluesofthebondsattime1.
Thetotalvalueofthebondatthelowestnodeattime0.5shouldbe:
0.5(98.72+1.)+4
1+
6.81%
2
= $1uu.24.
Similarly,goingbacktotime0,thevalueofthebondshouldbe:
0.5(96.78+1.24)+4
1+
.09%
2
= $99
0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
100.6
104

0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99 98.716
100.24 99.7719
100.6
104

5Spreadsd onality uetoopti

Lets s dthink we done:seemingly,all c
usingtreesofinterestrates! fcalculationsmakeusmissdearlythesimple
thatweusedtodo:allweneedisjustay curveandthenwewilljustdiscount1year flows
the1yeardiscountrate,2yearcash usingthe2yeardiscountrateandsoon,allweneed
takea tepbackan aboutallthat have ofasudden,
discou
wepri ebonds
cises Aloto ntingexer
cash ield
flows using to
AdvancedFixedIncome CallableBonds ProfessorAnhLe
careaboutistheconsistencybetweenthetimingofthecashflowsandthehorizonoftheinterestrates.
Allweknowis:allofasudden,lifegetssocomplicated!Canwegetbacktothesimplediscounting
alculations?
reethatwestartwith(whichIputbelowtosaveyoutimeflippingback
c
Alright,letsdothat.Fromthet
thepages),Icancomputetheinterestratesfordifferenthorizons.

0 0.5 1 1.5
15.44%
11.91%
9.19% 11.44%
7.09%

Horizon Interest
0.5 7.09%
1 7.54%
8.83%
6.81% 8.48%
6.54%
6.28%
1.5 8.03%

Iassumethat youkn howt interestratesofdifferenthorizonsfromaninterestrate

tree.Andassuch,Iwontshowth ofmy Howeve r inghowI
gottheabove rates, should backto erestRate els.
Pri noncallab
2 8.55%
allof ow ocalculate
edetails calculationshere.
mynotesonInt
r,ifyoua ewonder
interest you go Mod
cingofthe lebond:
Giventheaboveinterest ordertopricethe callablebond, wene oisto
discountitscashflowsusingtheappropriateinterestrates:
4
rates,in 2yearnon all edtod
P =
1 +
7.u9%
2
+
[1 +
7.S4%
2
4

2
+
[1 +
8.uS%
2
4

3
+
[1 +
8.SS%
2
1u4

4
= $99.1u
Youcanseethattheprice,$99.10,matcheswhatwegotbeforefromtheinteresttree.

Pricingofthecallablebond:
However,whenitcomestopricingthecallablebond,withoutthetree,wearestuck!Fromourearlier
calculations,weunderstandthatthepriceofthecallableislower

thanthepriceofthenoncallableand
shouldbe$98.87.Butitseemsthat,withouthavingthetreetodeterminewhenitisoptimaltocallthe
bond,wewontbeabletoarriveatthisprice.
Sometraders,however,dontliketocarryabulkytreearound.Theypreferthe ofthefamiliar
ble(duetoits
callability)willbecheaperthanitsnoncallablecounterpart,inordertopricethecallablebond,they
ratesusedtopricethenoncallable.Letssaythespreadis13basis
easiness
discountingexercises.Assuch,theydecidetodothefollowing:sincetheyknowthecalla
willaddaspreadtothediscount
points.Thepriceofthecallablebondwillbe:
AdvancedFixedIncome CallableBonds ProfessorAnhLe
P =
4
1 +
7.u9%+ u.1S%
2
+
4
[1 +
7.S4%+ u.1S%
2

2
+
4
[1 +
8.uS%+ u.1S%
2

3
+
1u4
[1 +
8.SS%+u.1S%
2

4
= $98.87
whichexactlymatchesthepriceofthecallablebondwehaveabove.IamsureyouknowhowIcome
withsuchaspreadthatgivestheexactpriceof
up
$98.87Solver,whatelse?
Oncewehavethisspread,itisseeminglyconvenientbecausewecanthencarrythespreadaroundand
priceothercallablebondsbyaddingthesamespreadtotheirdiscountrates.Thispracticeisdangerous,
however,sincethevalueofacalloptionisdifferentfrombondtobonddependingontheircoupon
rates,theircallpriceetc.Assuch,pleasebecarefulifyoueverdothisatwork.Ifyoutreasuresafety,I
wouldrecommendusinganinterestratetree.
6Zerovolatilityspread(orZspreadorstaticspread)
Wehavebeenusingtheriskfreeinterestratetreetopricethesetwobondswiththeimplicit
assumptionthattheycomewithoutdefaultrisk.Thisisnotreasonable.Infact,accountingfordefault
risk,liquidityrisketc.,pricesofthebondswouldbelowerthanwhatwehadpreviously.Letsassume
thatbecauseofthesefactors(defaultrisk,liquidityrisk),thecallableisonlysellingfor$97.33insteadof
$98.87.Tolookforaspreadforthisbond,weagainchooseanumbersthatwhenaddedtotheriskfree
discountrateswillrecoverthemarketpriceof

$97.33.
$97.SS =
4
1 +
7.u9%+ s
2
+
4
[1 +
7.S4%+ s
2

2
+
4
[1 +
8.uS%+ s
2

3
+
1u4
s
[1 +
8.SS%+
2

4

ofthebondbutalsothecreditandliquidityrisks
associatedwithit.
Thisspreadiscalledthezerovolatilityspreadorthezerospreadorthezspreadorthestaticspreadof
thebond.Nowzspreadorzerospreadisjustashortformforzerovolatilityspread.Whyi itcalled
is
erestrates(likewhatwehavehere)asopposedtoonethatcomesoffatreelacks
thevolatilityelement,henceiscalledzerovolatilityspread.
UsingSolver,Ihaves=100basispoints.Notsurprising!Fromthelastsection,evenwithoutcreditand
liquidityrisk,andjustduetooptionality,wealreadyhaveapositivespreadof13basispoints.Nowthe
bondhasmorerisksattachedtoit,thepriceisreducedtoreflecttheextrarisks,assuchthespread
shouldbelargertoaccountfornotonlytheoptionality
s
zerovolatilityorstaticspread?Well,itisstaticrelativetootherspreadsthatcomeofftheinterestrate
treethatwewouldconsiderinthenextsection.Looselyspeaking,aspreadthatcomesoffabulkytree
seemsmoredynamic.Likewise,withatree,we,sortof,seethevolatilityofinterestrates.Ifthetree
fat,interestratesarevolatile,ifitisthin,interestratesarestable.Assuch,aspreadthatcomesfrom
justtheriskfreeint
Namingbusinessaside,twothingsareimportantaboutstaticspreads:
AdvancedFixedIncome CallableBonds ProfessorAnhLe
Ittakestheshapeoftheyieldcurveintoaccount(sinceitisaconstantspreadaddedtoeachof
thediscountrateforeachmaturityweneedayieldcurvetocomputethespread)
Itissomesortofatotalspreadsinceitincludeseverything:someelementofoptionality,some
elementofcreditrisk,someelementofliquidityrisketc.
7Optionadjustedspread
Optionadjustedspreadisanimportant(thoughpotentiallyconfusing)conceptoftenusedincontextsof
callablebond,mortgage,mortgagebacksecuritiespricing.
wing
enticalbondissuedbythesame
issuerexceptthatitisnoncallable.Imaketheprevioussentenceboldtoshowthatitisimportantto
tterunderstandingtheconceptofoptionadjustedspread.
thenoncallablebecausethezspread
ofthecallablebondincludeseverything.Itincludesnotonlycreditrisk,liquidityriskbutalsothe
ty
o
me
Naturally,therefore,wewouldliketotakeawaythepartthatisduetooptionalityofthecallableand
the
Staticspread=optionadjustedspread+spreadduetooptionalityofthebond

appropriate!Thattreewasdefaultfree.
Nowthatourbondsaresubjecttodefaultrisksandliquidityrisks,weneedtodiscounttheircashflows
heavier.An spreads
toeachoftheinterestratesinthebinomialtree.Thatway,wewoulddiscountthebondscashflows
Tounderstandoptionadjustedspreadaswellaswhyithassuchaname,thinkaboutthefollo
situation:Weobservethepriceofthecallablebondtobe$97.33andwewouldliketousethis
informationtomakesomeinferencesregardingthepriceofanid
bearthiscontextinmindinbe
Alright,fromthecalculationsintheprevioussection,weknowthatthezspreadofthecallablebondis
100basispoints.But,ofcourse,wecantusethisspreadtoprice
optionalityofthecallablebond.Whilethepartofthespreadthataccountsforcreditriskandliquidi
riskshouldbethesameforboththecallableandnoncallablebonds,thenoncallablebondhasn
optioninit.Assuch,itwouldbeunfairtopricethenoncallablebondusingaspreadthatincludesso
optionalitycomponentinit.
usetheremainingparttopricethenoncallablebond.Thismakessensebecauseifyoutakeawaythe
optionalitycomponentfromthecallableszspread,theremainingspreadmustbeduetocreditrisks
andliquidityriskswhicharethesameforboththecallableandnoncallable.Thisspreadiscalled
optionadjustedspread.Thenamederivesfromthefactthatwestartfromthestaticspreadofa
callableandinordertopricethenoncallable,weneedtoadjustthespreadfortheoptionality
componentinit.Totieeverythinginanequation,wehave:
Buthowwouldwedothat?Howcouldwedisentangletheoptionandnonoptioncomponentsofthe
staticspreadofthecallablebond?Theanswer:Weneedaninterestratetree.Youmayhaveawhya
treequestionrightnow,butletmedeferansweringthatquestionlater,letmeshowyouhowwefind
theoptionadjustedspreadfromatreefirstandthenexplainwhylater.
Firstofall,theinteresttreethatweusedbeforeisnolonger
dweneedtodothatateverynodeofthetree.Thissuggeststhatweneedtoadda
heavierateverynode.
AdvancedFixedIncome CallableBonds ProfessorAnhLe

15.44%+s 15.44%
11.91% 11.91%+s
9.19%+s 11.44%+s
9.19% 11.44%
7.09% 8.83%
6.81% 8.48%
6.54%
6.28%
7.09%+s 8.83%+s
6.81%+s 8.48%+s
6.54%+s
6.28%+s

Inlookingfortheoptionadjusted thecallablebondwhichissellingatt$97.33,Iwi
spreadsinawaythatw theresultingtree(ontherightabove)toprice ,itwould
recoverthem lueoftheca n 7.33).Asusua sscanonlybe l
and canbeautomatedbythe ct .
IwillleavetheSolverpar .Fornow,tofurtherillustratehowtheprocess strya
randomvalueofs=99basispoints. 99basispoints,wewillhaveanewtreeofinteres
ccountsfordefault/liquidityrisksofthebond.Thetreewillbeasfollows:
spreadof llchoosea
henIuse thecallable
arketva llablebo d(at$9
Solverfun
l,thisproce donebytria
errorwhich ioninExcel
ttoyou works,let
Ifits= tratesthat
a

0 0.5 1 1.5
96.103
0 0.5 1 1.5
16.43%
12.90%
10.18% 12.43%
4
94.8869
95.48639 97.9142
97.33178 97.807
99.0416 99.3003
100
8.08% 9.82%
7.80% 9.47%
7.53%
7.27%
100.3528

Uponhavingthetree,wecanuse topriceourcallablebondfollowingtheusualproces
spaceandtime,Iwillno detailsofthepricingprocess.Rather,Ijustinclu efinaltree
ofbondvalu like,youcan e calculationsyourse kyouranswe
aga Ifyouaren howtoprice bon interestratet sereferto
section4ofth .Inpricingthe rememberthatthisbondhas eof$100,p
semiannualcouponrate canbecalledforacallpriceof$100attime1.0and 1.0only.
NotethatIpaintblueallthenodes edadjustmentsduetothecallfeatureofthecallab
Amazingenough,withaspreadof99basispoints,weindeedrecoverthemarketpriceofthecallable
n
thetree s.Tosave
tshowthe dehereth
es.Ifyou doallth pricing
acallable
lfandchec rs
instmine. otsure dusingan ree,plea
isnode bond, afacevalu aying
of8%and time
thatne lebond.
bondwhichis$97.33.Ok,soIcheated.Isaidletstryarandomvalueofs=99basispoints.Thevalue
of99basispointsIchosetotrywasnotrandom.IusedSolverinExcelandworkedoutthats=99basis
pointswouldgivemethepriceofthecallablebondthatIwant($97.33).
Hopefully,bynowyouunderstandatleastinatechnical,mechanicalsensehowtocomputetheoptio
adjustedspreadfromtheinterestratetree.(AndasImentionearlier,comparedtothestaticspread,
thisoptionadjustedspreadseemsmoredynamic,lessstaticflavorsinceitcomesoffatree.)Still,you
AdvancedFixedIncome CallableBonds ProfessorAnhLe
maybewonderingwhysuchaprocedurewouldgiveustheexactspreadthatwewanttheoption
adjustedspreadthespreadthathasnooptioncomponentinit.
Fairenoughletmeexplainit.
Inexplainingit,Ifindithelpstolookbackandseehowthingsmovealong.First,wepricethenon
callabledefaultfreebondtobe$99.10.Second,weshowthatifthebondbecomescallable,thecallab
defaultfreebondshouldbepricedatalowervalueof$98.87,areductionof$0.23.Finally,ifweallow
forthefactthatthebondisdefaultable,thepriceofthecallabledefaultablebondshouldbeevenlow
at$97.33,anadditionalreductionof$1.54.
le
er
reductionsinbondpriceoccurindifferent Itisimportanttorecognizethat,inusingthetree,thetwo
manners.
bond.Itisimportanttounderstandthatallwedohereisto
adjustthecashflowsdownwards.Weneverhavetomodifyourinterestratesateachnodeof
accountfordefault/liquidityrisks,unlikehowweallowforcallability,wedontforcibly
modifythecashflows.Instead,wesimplydiscountthecashflowsheavier.Thisinvolvespushing
Toaccountforthecallabilityofthebond,weadjustdownwardsthevaluesofthebondsattime
1.0atnodeswhereitisoptimalfortheissuertocallthebond.Thisisbecausetheissuerofthe
callablebondwilloptimallycallthebondwheneverthevalueofthebondisgreaterthanthecall
pricehe/shehastopayincallingthe
thetreetoaccountforthecallabilityofthebondbecauseitisunnecessary.
To
upourinterestratesateachnodeofthetreebyapositivespread.
Ifyoucanthinkofpricingasgenerallydividingexpectedfuturecashflowsby(1+thediscountrate),or
pricc =
Lxpcctcd Putuc Cush ]Iows
1+dscount utc
,thelooselyspeaking,thefirstpricereduction(toaccountforthe
bondscallability)occursthroughareductionoffuturecashflows(areductioninthenumerator).Onth
otherhand,thesecondpricereduction(toaccountforthebondsdefault/liquidityris
e
ks)occursthrough

wealreadyaccountforthecallabilityofthebondbyadjustingthecashflowsdownwheneverthe
ondiscalled,thespread(99basispointsintheaboveexample)weaddtotheriskfreeinterestrate
anincreaseinthediscountrate(anincreaseinthedenominator).

Since
b
CF
Pushingthe
wholetre

eup
Howtoadjustforcallability
Adjustingcashflowsdown
whenthebondiscalled
Howtoadjustforcreditrisks/liquidityrisks
AdvancedFixedIncome CallableBonds ProfessorAnhLe
treehasnothingtodowiththecallabilityofthebond.Inotherwords,suchaspreadbywhichwepush
thewholetreeupinpricingthecallableonlyaccountsforthecreditrisksandliquidityrisksofthe
allablebond.Therefore,thespreadof99basispointsthatwefoundaboveistheoptionadjusted
preadthatweneedaspreadwithouttheoptionalitycomponent!
c
s
Oncewefindtheoptionadjustedspread,wecanuseittopricethenoncallablebondsincewewould
haveanewinterestratetreethatallowsforthecredit/liquidityrisksofthebondissuer.
0 0.5 1 1.5
16.43%
12.90%
10.18% 12.43%

0 0.5 1 1.5
96.1034
94.8869
95.48639 97.9142
8.08% 9.82%
7.80% 9.47%
7.53%
7.27%
97.34568 97.807
99.0705 99.3003
100.0601
100.3528

Usingthetree th lla shouldbestraightforward s

thecallablebon for optimal the call
bond. ,Iwont thr detailsof ingprocess Rath
resultingprice yo calculationsto.
Accordingtomycalculations,thefin ofthenoncallablebondis$97.35,justslightlyab
riceofthecallablebondat$97.33.Thismeansthatthevalueofthecallablefeatureisonly$0.02?Orin
ticspreadis100basispoints,thespread
duetooptionalityisreallysmall:10099=1basispoint!Thisiscrazy!Duetoourcalculationsearlier,the
?
Ifthefirmhascreditrisks/liquidityrisks,itsbondshouldgenerallysellforlesscomparedtothecase
whenithasnocred ebecauseto
ofthedefaultablebondisalwayslessthanits
defaultfreecounterpart.
toprice
dbecause
enonca blebond
evenhave
andeven
for
implerthan pricing
the wedont
oughthe
tocheck
thepric
whenitis
here.
issuerto
puthere Again go
treefor
er,Iwould the
utocompareyour
alprice ovethe
p
otherwords,ifwegobacktoourequation:
Staticspread=optionadjustedspread+spreadduetooptionality
Sincetheoptionadjustedspreadis99basispointsandthesta
spreadduetooptionalityis13basispoints(remember?).Whathappenstoitthatreducesitby13fold
Answer:theextracredit/liquidityrisks.Butwhy?
itorliquidityproblems.Thisshouldbetrueateverynodeofthetre
accountforcredit/liquidityrisks,weneedtousehigherdiscountratesateverynodeofthetree.To
betterillustratethis,Iwillputthepricetreeofthenoncallablebondwithandwithoutcredit/liquidity
riskstogetherandhopefullyyoucanhaveasenseofwhatImean.Justcomparinganypairof
correspondingnodes,youwouldseethatthevalue

AdvancedFixedIncome CallableBonds ProfessorAnhLe

Defaultfreenoncallablebond Defaultablenoncallablebond
0 0.5 1 1.5
96.5451
95.75492
96.7878 98.3727
99.10046 98.716
100.4394 99.7719
101.0012
100.8344
1.5 0 0.5 1
96.1034
94.8869
95.48639 97.9142
97.34568 97.807
99.0705 99.3003
100.0601
100.3528

Asaconsequence,thevalueoftheca theissuerofthedefaultablecallablebondwill
smaller.Thisshould cle nodeattime1where two
will of d greaterthan the the
each Th the ltfr pocketsthe of betwe the
thebond(ifle calling($100).Ontheother ,the the
defaultablebondearnsonly
notherwayofthinkingaboutthisis:relativetothedefaultfreecase,ifyouhavetheextra
call
is
ksto1basispointwhenweallowforcredit/liquidityrisks.
model
aswellasmodelrisks.
del
lloptionto be
be
thevalue
arbylookingatthelowest
hereis
theissuer
comparing
ofthe bonds
callto call(because
issuer.
thebon
defau
$100)and
difference
valueof
en eissuerof
talive)and
eebond
topayin
$1.00012
hand
valueof
whathehas
$0.0601.
issuerof

A
credit/liquidityrisksandthushavetofacerelativelyhigherborrowingcosts,youwillbelesslikelyto
thebondthesamewayyouwillbelesslikelytorefinanceyourmortgageifthecurrentinterestrates
arehigh.Ifyouarelesslikelytocallthebond,itsvalueshouldbesmaller.
Andifthevalueofthecallablefeaturebecomessmaller,naturallythespreadduetooptionality
becomessmalleraswell.Thisexplainswhythespreadduetooptionalityhasdecreasedfrom13bas
pointsincaseofnodefault/liquidityris
Assomefinalwordsofcaution,theoptionadjustedspreadmeasuresthatwelearnsofarare
dependent.Inotherwords,weneedsomeinterestratetreesomemodelofinterestratetocalculate
thismeasure.Wheneverwetalkaboutmodel,thereisoneextradimensionofrisk,namelymodelrisk.
Assuchtobeprecise,theoptionadjustedspreadcontainscredit/liquidityrisks
Thepartsrelatedtocredit/liquidityrisksshouldbepositive!However,thepartrelatedtothemo
risks,itcouldbepositiveornegativedependingonhowweconstructthemodel.
8Callablebondpricesandinterestrates
AsIalreadymentionedintheintroclass,bondpricesandinterestratesareliketwoendsofaseesaw
Wheninterestratesgoup,bondpricesgodownandviceversa.Thesameanalogyappliestothe
relationshipbetweencallablebondpricesandinterestrates.Ifyouplotthepriceofthe2yearcallable
bondconsideredearlieragainstinterestrates,youwillhaveanegativelyslopedgraphasyouwouldfor
otherbonds.
.

However,asIshowedabove,sincethe2yearcallableisboundedfromabovebypricesofthe1year
le,thepricingfunctionofthe2yearcallablebondwilltakea noncallableaswellasthe2yearnoncallab
AdvancedFixedIncome CallableBonds ProfessorAnhLe
somewhatspecialshape.Inthegraphbelow,Iplotthepricingfunctionofthe2yearcallablebond(in
purplecolor)togetherwiththatofthe1year(inredcolor)and2year(inbluecolor)noncallable
forcomparisonpurposes.
bonds

Wheninterestratesarereallyhigh,borrowersarelesslikelytorefinancetheirborrowings.Inother
words,therearehighchancesthattheissuerwillletthebondliveuntilmaturitywithaveryhigh
probability.Inthesecases,thecashflowsfromthecallableareverymuchsimilartothosecomingfrom
the2yearnoncallablebond.Thisexplainswhytheshapeofthepurplegraph(callablepricingfunction)
comesveryclosetothatofthebluecurve(2yearnoncallablepricingfunction)asinterestratesrise.In
theotherextreme,wheninterestratesarelow,borrowersarehighlylikelytorefinancetheir
borrowings.Iftheissuercallsthe2yearcallablewithaveryhighchance,thecashflows omthe
callableareverymuchlikethosecomingfromthe1yearnoncallable.Thisexplainswhythepurple
lly
tion,we

uch
Finally,intheintermediaterangeofinterestrates,thepricingfunctionofthecallabledisplaysa
t
fr
graphcomesveryclosetotheredgraph(1yearnoncallablepricingfunction)asinterestratesgorea
low.
Wecanseethatasinterestratesdecrease,thepricingwedgebetweenthe2yearcallableand2year
noncallablebecomesmoreandmorepronounced.Thisdifferenceispreciselyduetocallablefeature
attachedtothecallablebond.Thisdifferenceisthevalueofthecallabilityofthebond.Inaddi
canseefromthegraphthatgivenareductionininterestrates,bondswouldgenerallyappreciatein
values.However,duetothecallablefeature,theextenttowhichcallablebondspricesincreaseism
lessthanthatforthe2yearnoncallable.Thisphenomenonisreferredtoaspricecompression.
negativelyconvexshape.Ifweareworriedsinceyouarenotsurewhatnegativeconvexitymeans,don
worrywewilltacklethatwithmoredetailsshortlyinthenextsection.

AdvancedFixedIncome CallableBonds ProfessorAnhLe

9Duration/dollardurationandconvexity/dollarconvexityofcallablebonds
Beforetalkingabouteitherdurationordollardurationofcallablebonds,Iwouldliketoremindyouof
howIshowed,inourintroclass,thatthedollardurationofbondsissimplytheslopeofthetangentline
fthepricingfunction.Afterall,(dollar)durationmeasuresthesensitivityofbondpricewithrespectto
changesininterestrates.Iftheslopeofthetangentlineissteep,agivenchangeininterestratewilllead
alargechangeinbondprice.Ontheotherhand,whenthetangentlineisratherflat,agivenchange
.
o
to
ininterestrateswillonlycauseasmalldeviationinbondprices.
Itturnsoutthatdollardurationaswellasdurationofregularbondsdecreaseasinterestratesincrease
Whyisthat?Justthinkofhowyoucomputedurationofazerocouponbond:
1
1+
j
2
whereTismaturity
andyisthesemiannualinterestrate.Obviously,asinterestrates(y)increase,durationgoesdown.
Graphicallyspeaking,aswemovealongthepricingfunctionofregularbonds(likewhatwehavebelow
onthelefthandside),theslopeofthetangentlinegraduallydecreasesthebondbecomeslessand
lesssensitivetochangesininterestrates.
Positiveconvexity Negativeconvexity

Itispreciselythisdecreaseindurationasinterestratesincreasethatgivesrisetopositiveconvexityfor
theregularbonds.TocontrastbetweenpositiveconvexityandnegativeconvexityIalsoincludeonthe
righthandsideanexampleofnegativeconvexity.Thereyouseethatasinterestratesincreasethe
tangentlinesbecomesteeperandsteeper.
Anotherinterestingobservationisthat:
Withpositiveconvexity,thebluecurvealwaysliesabovethetangentlines.Ifyouremember
ethe
curveinsteadalwaysliesbelowthetangentlines.Thistime,
thedifferencebetweenthebluecurveandtheredlineisalwaysnegative.Assuchtheconvexity
adjustmentforthiscasewillalwaysbenegativehencethenamenegativeconvexity.
wellthedurationandconvexityapproximation,thedifferencebetweenthebluecurveandthe
redtangentlineispreciselywhatourconvexityadjustmentsgoafter.Ifthebluecurvealways
liesabovetheredline,thisexplainswhyourconvexityadjustmentisalwayspositivehenc
namepositiveconvexity.
Withnegativeconvexity,theblue
AdvancedFixedIncome CallableBonds ProfessorAnhLe
Letsnowgetbacktoour2yearcallablebondandthinkaboutitsdollardurationandhowitwillchan
asinterestratesincrease.Forillustrationpurposes,Iplotonagraphherethe$durationofthe2year
noncallable(inblue)andthe$durationofthe1yearnoncallable(inred)togetherwiththe$duration
ofthecallablebond(inpurple).Youcanseethatthe$durationofthe2yearnoncallableand1year
noncallabledecreaseasinterestrates
ge

increaseasIexplainedabove.Inaddition,$durationofthe2year
uration
ofthecallablechangesasinterestrateschange.

Forreallylowinterestrates,borrowersarelikelytorefinancetheirborrowingsequivalently,
therearehighchancesthe2yearcallablebondwillbecalled.Therefore,forverylowinterest
rates,the2yearcallablebondbehavesverysimilarlytothe1yearnoncallable.Assuch,forthe
lowrangeofinterestrates,theduration/dollardurationofthe2yearcallablewilllookvery
muchlikethatofthe1yearnoncallable.Inotherwords,thepurplegraphshouldcomereally
closetotheredlinewheninterestratesarereallylow.
Forreallyhighinterestrates,borrowersarealmostcertainnottorefinanceorinotherwords,
therearehighchancesthatthe2yearcallablewithliveuntilmaturity.Assuch, thehigh
rangeofinterestrates,theduration/dollardurationofthe2yearcallablewilllookverymuch

.
,meansthat$durationofthecallable
noncallableisalwayshigherthan$durationofthe1yearnoncallable.Thismakessensesincefora
longermaturity,the2yearnoncallableshouldbemoresensitivetointerestratechangesthanthe1
yearnoncallable.Letmeknowexplaintheshapeofthepurplegraphwhichtellsushowthe$d
for
likethatofthe2yearnoncallable.Inotherwords,thepurplegraphshouldcomereallycloseto
thebluelinewheninterestratesarereallyhigh.
Fortheintermediaterangeofinterestrates,wedontknowexactlyhowthepurplegraphwill
turnout.However,onethingweknowforsureisthatthepurplegraphshouldbecontinuous
Togetfromwhereitiswheninterestratesarelow(closetotheredline)towhereitiswhen
interestratesarehigh(closetotheblueline),therefore
bondwillincreaseasinterestratesincreaseatleastforsomeintermediaterangeofinterest
rates.
AdvancedFixedIncome CallableBonds ProfessorAnhLe
Asexplainedabove,thisbehaviorofduration(increasewheninterestratesincrease)creates
negativeconvexity.ThisisexactlywhatweseefromthefigureIincludeinsection8,whichIwillput

Onewaytothinkabouthowthisnegativeconvexitycomesaboutistoimaginethatyouaredriving
alongtheredcurveandapproachingwhetherthebluecurveandtheredcurveinterests.Thenyou
wanttomakearightturnintothebluecurve.Whenyouaremakingarightturn,aslongasyouare
notgoingdeadlyslow,youwillmakeabendingshapesimilartothepurplegraphthatwehave,
whichisnegativeconvexity.
Afterall,whatisthedealaboutnegativeconvexity?Whyisitsoimportantthatwehavewasted
quitesometimetalkingaboutit?Itturnsoutthatithasquiteimportantimplicationsinhedging,
especiallyforthosecompaniesthatinvestinfixedratemortgagesthat,asyouwillsee teron,also

s.
10ComputationofDuration/dollardurationandconvexity/dollarconvexityofcallablebonds
hereagaintosaveyoutimeflippingback:
la
displaynegativeconvexity.Inminimizingtheirexposuretointerestraterisks,naturallythesefirms
wouldliketobalance/matchthedurationsandconvexitiesoftheirassetsandliabilities.Therefore,if
theyhavenegativeconvexityassets,theywouldliketohavenegativeconvexityliabilitiesthatgive
themanaturalhedge.Andonewaytohavenegativeconvexityliabilitiesistoissuecallablebond

Asy nt
from
dur
you
sho
con
themfromtheothermeasuresthatwehavelearnt.Forthesakeofbrevity,inwhatfollows,Iwillomit
tand
thatIrefertoeffective(dollar)durationsand(dollar)convexity.
oualreadysee,unfortunately,durationandconvexitymeasuresofcallablebondsarequitediffere
thoseofthemoreregularbonds.Duetothis,allthetechniquesthatwelearnincomputing
ationandconvexityfortheregularnoncallablebondsarenolongerapplicablehere.Iwillfirstshow
theprocessbywhichwecancomputethe(dollar)durationofthe2yearcallablebond.Next,Iwill
wyouhowtheconvexitycanalsobecomputed,usingasimilarprocess.Thesedurationand
vexitymeasuresarecalledeffective(dollar)durationandeffective(dollar)convexitytodifferentiate
thewordeffectiveinfrontofdurationandconvexitywiththeimplicitassumptionthatyouunders
AdvancedFixedIncome CallableBonds ProfessorAnhLe
(Dollar)Duration:
First,Imentionedearlier,dollardurationistheslopeofthetangentlinetothepricingfunctionofany
bond,callableornoncallable.Fornoncallableregularbonds,fortunately,wehaveformulas.With
callablebonds,however,wedonthavethatluxury.Tocompute(dollar)durationforacallableb
needtogothroughasetofstepsthatturnouttobeapplicabletoeverybond:
1. First,wecomputethecurrentvalueofthebondatthecurrentlevelofinterestrates.Letssay
thecurrentvalueofthebondisV
0
.
2. Second,weincreasetheinterestratelevelbyasmallam
ond,we
ounty.Howsmall?Somethingsmaller
ispointswouldbesmall.Wethencomputethevalueofthebondatthisnewlevelof
interestratesandcallitV
+
.

than10bas
3. Third,wedecreasetheinterestratelevelbythesamesmallamountyandcomputethevalue
ofthebondatthisnewlevelofinterestratesandcallitV

.
4. Dollardurationofthebondwouldbe
v
+
-v
-
2A
.
v
+
-v
-
5. Durationofthebondwouldbe
2v A
0
.
se.Myexplanation(thoughshortandintuitive)onlyserves
anactuallyimplementthesesteps.

Basically,ifwehaveaniceandneatequationthatgivesustheslopeofthetangentlinetothepricing
functionordollarduration,thatwouldbenice.Otherwise,theslopeofthetangentlinewouldbesimilar
totheslopeofthebrowndottedlineonthegraphabove.Thisdottedlineconnects2pointsontheblue
curve:thefirstpointiswhenwedecreaseinterestratesbyasmallamountyandthesecondpointis
Iwillnowexplainwhythesestepsmakesen
thepurposeofsatisfyingthosecuriousaboutthereasoningbehindthesesteps.Itwontbeonthetest.
Assuch,thoseofyouwhothinkthatitistoomuchtoreadalready,youcanskipthissectionandgo
straighttotheexampleofhowwec
AdvancedFixedIncome CallableBonds ProfessorAnhLe
whenweincreaseinterestratesbythesamesmallamounty.Theslopeofthislineissimply
v
+
-v
-
2A

whichistheformulaweuseforthedollarduration.Sinceduration=dollarduration/price,theduration
ofthebondissimply
v
+
-v
-
2v
0
A
.
Importantly,noneofthestepsisparticulartocallablebonds,whichmeans:theprocessisapplicableto
anykindofbondsorinterestratesensitivesecurities.
Toprovideaconcreteexampleofhowtocarryouttheabovesteps,letsconsidercomputingthedollar
durationanddurationofour2yearcallablebond.
Thegoodnewsisstep1isalreadydonebecausewealreadypricethecallablebondinthe
precedingsections.Toremindyouofwhatwedid,Iincludeheretheinterestratetreeweused
aswellastheresultingpricetree.Again,nodespaintedbluearethoseaffectedbythebond
beingcalledattime1.
0 0.5 1 1.5

0 0.5 1 1.5
96.1034
94.8869
95.48639 97.9142
97.33178 97.807
99.0416 99.300
16.43%
12.90%
10.18% 12.43%
8.08% 9.82%
7.80% 9.47%
7.53%
7.27%
3
100
100.3528
SoourV
0
=97.33.
Instep2,weneedtoincreaseinterestratesbyasmallamounty.Letsassumey=10basis

thetreetopricethecallablebondagain.Again,I
willnotgivethedetailsofthepricingcalculationsbutratherpostheretheresultingpricetree
points.Wewilltalkalittlebitaboutthislater,butfornowwewilladd10basispointstoeachof
thenodeoftheinterestratetreeandthenuse
foryoutocompareyourcalculationsagainst.
0 0.5 1 1.5
16.53%
13.00%
10.28% 12.53%
8.18% 9.92%
7.90% 9.57%
7.63%
7.37%

0 0.5 1 1.5
96.0591
94.79989
95.35627 97.8682
97.17068 97.7159
98.9337 99.253
99.9658
1

00.3044
AdvancedFixedIncome CallableBonds ProfessorAnhLe
Asyoucansee,asinterestr reaseby10basispoints,bondpricedecreas
+
=$97.17.
Itturnsoutthatatnowherealongthetreethatitisoptimaltocallthebondgiventhis
rthisreason,wedonthaveanybluenodesthistime.

atesinc etoV
increase
ininterestrates.Fo
Step3issimilartostep2,exceptthatwenowsubtract10basispointsfromtheoriginalinterest
ratetree.Theresultingratetreeandpricetreeareasfollows:

0 0.5 1 1.5
16.33%
12.80%
10.08% 12.33%
7.98% 9.72%
7.70% 9.37%
7.43%
7.17%
0 0.5 1 1.5
96.1479
94.97404
95.61675 97.9604
97.4853 97.8982
99.1332 99.3478
100
10

Asinterestratesdecrease,bondpriceincreasestoV

=$97.49
GivenV
follows:

2A
0.4012

+
,V

,V
0
andy=10basispoints,wecancomputethebondsdollardurationanddurationas

Dollarduration=
v
+
-v
-
=
97.17-97.49
20.0010
= -16u.
Duration=
oIIu duuton
pcc
=
-160
97.33
= -1.64S9.
Thenegativesignsinfrontofdollardurationanddurationarejusttoindicatethatbondpricesand
interestratesmoveinoppositedirectio as estratesincr se,bond cesdecreaseandvice
versa.
(Dollar)Convexity:
ns: inter ea pri

Itt thatitisquit tforwardtocomputeconv dollarconvexi uhaveV

+,
V

andV
0
allre illfirstshowy formulastoperformthenee lations.Next,
curious,Ibrieflyandgrap explaintheideasbehindtheformulas.Again,thispartw tbeonthe
test.Therefore,ifyouarenotintere reasoning,youcouldsafelyskipit.
Tocomputedollarconvexity,weusethefollowingformula:
v
+
+v
-
-2v
0
(A)
2
urnsout estraigh exityand tyonceyo
ady.Iw outhe dedcalcu forthose
hically illno
stedin
2
.
2(0.0010)
2
PluggingthevaluesforV
+
,V

,V
0
intheformula,dollarconvexityofthecallablebondis:
97.1707+97.4853-297.3318
=3800.
AdvancedFixedIncome CallableBonds ProfessorAnhLe
convexity,wesimplydivi bytheprice,whichwillgive:
-3800
Tocompute dedollarconvexity
97.33
= -S9.u4.
Letmenowbrieflyprovidetheintuitionbehindtheformula:
v
+
+v
-
-2v
0
2(A)
2
Asyoucansee,the(dollar)convexityforthecallableisnegative.
fordollarconvexity.
Asyoualreadyknow,thewholeideaofconvexityadjustmentistocorrectforthedeviationsbetween
thebluecurveanditstangentline.Givenanincreaseofyininterestrates,thedifferencebetweenthe
bluecurveandtheredtangentlineisthedistanceCC
1
.Givenadecreaseofyininterestrates,the
differencebetweenthebluecurveandtheredtangentlineisthedistanceAA
1
.Althoughwedontknow
exactlywhatCC
1
andAA
1
are,weknowtheiraveragewhichisthedistanceBB
1
.TheheightofBissimply
theaverageofV
+
andV

.theheightofB
1
isV
0
.Therefore,thelengthofBB
1
issimply:
v
+
+v
-
2

-I
0
=
v
+
+v
-
-2v
0
2
. Thisexplainswhytheconvexityformula,
v
+
+v
-
-2v
0
2(A)
2
Isproportionalto
v
+
+v
-
-2v
0
2
.